I have been getting numerous questions about the situation with California's surging gasoline prices. I actually predicted this price surge for California back in August, and said that it would persist into the Fall. Many have suggested an oil company conspiracy. Therefore, I want to take some time to explain what makes California's gasoline situation unique.
The EPA defines gasoline specifications, but many states have more restrictive specifications. The reasons for this are varied, but are primarily a function of the climate and the population density of an area. A cold, sparsely populated location will not suffer the same air quality issues as a warm, densely populated area and therefore those two locations may require different fuel specifications. Fuel blends that are specific to specific states are called boutique fuels.
An example of this is called the Reid Vapor Pressure (RVP) of the fuel. It can be thought of as a measure of the temperature at which a fuel boils. A fuel with a very low RVP won't be lost to the atmosphere, but if it is too low it may not properly vaporize in the car's engine. A fuel with a high RVP will evaporate more quickly -- especially in high temperatures -- and contribute to ground-level ozone and poor air quality. Specifications vary for RVP between the summer and winter. Summer fuel has a lower RVP (i.e., it is harder to vaporize, but this is compensated for by the higher summer temperature) and is more expensive to produce than winter fuel.
California has strict fuel specifications, and its fuel is produced almost exclusively by California refineries. The specifications for fuel in surrounding states are different, so California is really an island as far as their fuel production is concerned. If they have a shortage, fuel can't flow in from neighboring regions due to their more restrictive specifications. This greatly increases the risks of a supply disruption in the case of refinery problems.
Oil refining is not a lucrative business most of the time (although oil production is), so refiners don't maintain a lot of spare capacity. One key to profits in a refinery is to keep refinery utilization high, and that has been the case in California. Refineries there need to run at a high utilization in order to make money. Or, another way to put it is that the refining sector usually has such tight margins that refiners can't afford idle spare capacity. The capital that they have tied up in equipment needs to be producing, and hence there is a tight balance between supply and demand.
The August refinery fire at Chevron's (NYSE:CVX) 245,000 bbl/day Richmond refinery reduced capacity there. I addressed this issue in an August episode of R-Squared Energy TV (How Ethanol and the Chevron Refinery Fire Impact Gas Prices -- starting at the 2:50 mark), explaining why we could expect to see gasoline prices rise in California relative to the rest of the U.S. I said that I expected price spikes on the West Coast to be significantly higher than price spikes in the rest of the U.S. and that I expected California to "struggle with gasoline prices until well into the Fall."
The Chevron fire alone was enough to drive gasoline prices in California higher, but an unplanned outage at an ExxonMobil (NYSE:XOM) refinery in Torrance further crimped supplies. In a market that was already seriously constrained, this resulted in very low gasoline inventories that caused some stations to completely running out of fuel. Obviously, in a case like this gasoline prices are going to rise, and if stations are running out of fuel they are going to rise sharply.
Some have suggested a conspiracy by oil companies to drive gasoline prices up in order to help Mitt Romney win the presidency. First of all, we don't need conspiracy theories when we understand the factors involved. If some choose to believe that Chevron or ExxonMobil purposely took production offline, then they are free to believe what they want. But this belief isn't realistic. When these companies take production offline, the cost to them will be greater than the benefit from higher gasoline prices. The companies that benefit are those that did not have production problems. So when a Chevron refinery goes down, the beneficiaries are Shell (NYSE:RDS-B), BP (NYSE:BP), Tesoro (NYSE:TSO), etc. Further, does anyone really think Romney could win California? One could make a slightly more believable case if this happened in a key swing state, but not for California.
Several solutions to the gasoline shortage have been suggested, but there are no easy answers. Clearly California could benefit from more refining capacity. That's a long-term solution, but because refining is normally such a low-margin business it is unlikely that anyone is going to step forward and build one. The people calling for more refining capacity are the same people complaining about high gas prices. But the only way a new refinery would get built is if gas prices are persistently high. So it's a Catch-22: The public and politicians want lower gas prices and more refining capacity, but the former makes the latter a poor bet.
Another option would be to temporarily relax California's specifications and allow fuel to be shipped into the area from neighboring states. First, I would assume that this is not something that the governor could simply decree; that it would need to work its way through the system. Second, it would necessarily drive up prices in neighboring states. These states have recently seen some relief from high gasoline prices, but if California starts siphoning off gasoline supplies that will change. Finally, it is very possible that relaxing these specifications will lower the air quality in certain areas.
One more option is further development of alternatives, but this is also a longer term solution. The current situation will encourage more people to purchase hybrids and electric cars, and at $5/gallon biofuels like ethanol will become more attractive. Compressed natural gas (CNG) vehicles should also gain traction as a result of this crisis.
While the ExxonMobil refinery has resumed operations, another potential shortage looms as the Phillips 66 (NYSE:PSX) refinery in Los Angeles will soon undergo planned maintenance. They have announced a slight delay in this maintenance to take advantage of current high prices (and certainly to avoid criticism for taking the refinery offline during this emergency), but they can't delay it forever. This sort of maintenance takes months to plan and involves many contract workers who may have other jobs scheduled, so it likely won't be delayed for long.
The situation in California is likely to persist for years. There is no simple solution to the problem, but there are steps individuals can take. Consumers have some control over the amount they spend on fuel by avoiding gas guzzlers, taking public transportation when they can, and carpooling whenever possible. Individuals who have long commutes may benefit from purchasing a hybrid or CNG vehicle.
California provides a valuable lesson for the rest of the country, because we are not immune to the problems there. Their special circumstances simply forced these issues to manifest themselves there first. But we will see these problems crop up in other areas, and I believe eventually across the United States. As a country we need to note what is happening in California and plan accordingly.
Link to Original Article: Understanding California's Gasoline Prices